FCA Handbook - MIFIDPRU 3.5A Tier 2 capital

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MIFIDPRU 3.5A Tier 2 capital

(1) Tier 2 capital has the following core characteristics:
1. (a) it ranks below ordinary creditors in liquidation;
2. (b) it has an original maturity of at least 5 years;
3. (c) it amortises over the final 5 years; and
4. (d) distributions do not accelerate when the firm experiences stress.
(2) The remainder of MIFIDPRU 3.5A contains detailed rules and guidance for calculating tier 2 capital.

A firm must calculate its tier 2 capital in accordance with the first column of the following table. The second column indicates where relevant rules and guidance are found.

Item		Relevant rules and guidance
Tier 2 items:
(1)	Tier 2 instruments;	MIFIDPRU 3.5A.3R to MIFIDPRU 3.5A.11R
(2)	share premium accounts related to the tier 2 instruments;
LESS
Deductions from tier 2 items:
(3)	direct, indirect and synthetic holdings of own tier 2 instruments;	MIFIDPRU 3.5A.12R and MIFIDPRU 3.5A.18R
(4)	direct, indirect and synthetic holdings of tier 2 or comparable instruments of financial sector entities where those entities have a reciprocal cross-holding with the firm; and	MIFIDPRU 3.5A.13R, MIFIDPRU 3.5A.14G, MIFIDPRU 3.5A.17R and MIFIDPRU 3.5A.18R
(5)	direct, indirect and synthetic holdings of tier 2 or comparable instruments of financial sector entities which are not held in the trading book.	MIFIDPRU 3.5A.15R to MIFIDPRU 3.5A.18R

Tier 2 instruments: loss absorption

(1) The claim on the principal amount of a tier 2 instrument must be wholly subordinated to the claims of all non-subordinated creditors.
(2) A tier 2 instrument must not be secured or subject to a guarantee or other arrangement which enhances the legal or economic seniority of the claim.
(3) A tier 2 instrument must not be subject to set-off or netting arrangements that would undermine its capacity to absorb losses.

(1) A tier 2 instrument must be fully paid and the proceeds of issue immediately and fully available to the firm.
(2) Where an instrument is partly paid, only the paid-up portion is eligible as a tier 2 instrument.

MIFIDPRU 3.3A.8G applies to tier 2 instruments as it applies to common equity tier 1 instruments.

(1) A tier 2 instrument must not be funded directly or indirectly by the firm itself.
(2) Paragraph (1) does not apply if the funding is provided in the ordinary course of the firm's business.

MIFIDPRU 3.3A.10G applies to tier 2 instruments as it applies to common equity tier 1 instruments.

Tier 2 instruments: duration

(1) A tier 2 instrument must have an original maturity of at least 5 years, with a reduction of capital prior to maturity only permissible where:
1. (a) the firm is in liquidation; or
2. (b) the firm carries out a reduction of capital which:
  1. (i) has been approved by the FCA under MIFIDPRU 3.6A.4R; and
  2. (ii) does not take place before 5 years after the date of issuance, unless the conditions in MIFIDPRU 3.6A.6R(1) or (2) are met.
(2) A tier 2 instrument must not include any incentive for the principal amount to be redeemed or repaid prior to maturity, or a right to accelerate early redemption or repayment.
(3) A firm must not explicitly or implicitly indicate that the tier 2 instrument would be redeemed or repaid prior to maturity other than in liquidation, and the terms of the instrument must not provide such an indication.
(4) Where the tier 2 instrument includes one or more early redemption options including call options, the options must be exercisable at the sole discretion of the firm.

(1) An incentive for the principal amount to be redeemed or repaid in MIFIDPRU 3.5A.8R(2) includes any feature that provides, at the date of issuance of a capital instrument, an expectation that the capital instrument is likely to be redeemed before its stated maturity date.
(2) Examples of an incentive under (1) include:
1. (a) a term which creates an economic incentive for the firm to reduce or repay the principal before maturity; and
2. (b) marketing of the instrument in a way which suggests to investors that the instrument will be called before maturity.

Tier 2 instruments: amortisation

Where a tier 2 instrument has a residual maturity of 5 years or less, the proportion of the instrument which qualifies as a tier 2 item must be calculated by multiplying A and B, where:
• A is the notional amount of the instrument on the first day of the final 5-year period of its contractual maturity divided by the number of days in that period; and
• B is the number of remaining days of contractual maturity of the instrument.

Tier 2 instruments: distributions

A tier 2 instrument must meet the following conditions regarding distributions:

(1) the holder of the instrument must have no right to accelerate the future scheduled payment of distributions, other than in liquidation; and
(2) the level of distribution must not change in a way that is linked to the credit standing of the firm or any member of the firm's group.

Deduction of holdings of own tier 2 instruments

(1) A firm must deduct direct, indirect and synthetic holdings of its own tier 2 instruments
(2) For the purposes of (1):
1. (a) a firm must also apply the deduction where it could be obliged to purchase the tier 2 instrument as a result of an existing contractual obligation;
2. (b) a firm must deduct its gross long position unless (c) applies; and
3. (c) a firm may deduct its net long position if:
  1. (i) the long and short positions are in the same underlying exposure;
  2. (ii) the short positions are cleared through an authorised central counterparty or subject to appropriate margining requirements; and
  3. (iii) the long and short positions are both held in the trading book or are both held outside of the trading book.

Deduction of holdings of tier 2 or comparable instruments where a firm has a reciprocal cross-holding designed to inflate own funds artificially

(1) A firm must deduct direct, indirect and synthetic holdings of the tier 2 or comparable instruments of financial sector entities where those entities have a reciprocal cross-holding with the firm designed to inflate the own funds of the firm artificially.
(2) For the purposes of (1), a firm must calculate holdings based on its gross long position.

The factors in MIFIDPRU 3.3A.26G indicate a reciprocal cross-holding designed to inflate own funds artificially.

Deduction of holdings of tier 2 or comparable instruments of financial sector entities

(1) A firm must deduct direct, indirect and synthetic holdings of tier 2 or comparable instruments of financial sector entities which are held outside of the trading book, unless MIFIDPRU 3.5A.16R applies.
(2) A firm must calculate holdings based on its the gross long position unless (3) applies.
(3) A firm may calculate holdings based on its net long positions where:
1. (a) (i) the maturity date of the short position is the same or later than the maturity date of the long position; or
2. (ii) the residual maturity of the short position is at least 1 year; and
3. (b) the long and short positions are held outside of the trading book.

Holdings of tier 2 instruments issued by a financial sector entity within an investment firm group

A firm is not required to deduct holdings of tier 2 instruments of a financial sector entity under MIFIDPRU 3.5A.15R if all of the following conditions are met:

(1) the financial sector entity forms part of the same investment firm group as the firm;
(2) there is no current or foreseen material, practical or legal impediment to the prompt transfer of capital or repayment of liabilities by the financial sector entity;
(3) the investment firm group is subject to prudential consolidation under MIFIDPRU 2.5; and
(4) the risk evaluation, measurement and control procedures of the parent undertaking include the financial sector entity.

Tier 2 or comparable instruments

(1) (for an entity subject to MIFIDPRU) a tier 2 instrument
(2) (for an insurer subject to the Solvency II Firms part of the PRA Rulebook):
1. (a) ‘Tier 2 basic own funds’ as defined in the Own Funds (Solvency II Firms) part of the PRA Rulebook; and
2. (b) ‘Tier 3 own funds’ that are ‘basic own funds’ as those terms are defined in the Own Funds (Solvency II Firms) part of the PRA Rulebook; and
(3) (for a financial sector entity not subject to (1) or (2)) any subordinated instrument that does not absorb losses on a going-concern basis.

Identifying and valuing indirect and synthetic holdings

MIFIDPRU 3.3A.30R (Identifying and valuing indirect and synthetic holdings) applies to holdings of tier 2 instruments as it applies to holdings of common equity tier 1 instruments.